Leveraged Buyouts: On the Level?

By Benjamin J. Stein; Benjamin J. Stein is a writer who lives in Los Angeles.

Published: January 17, 1988

FOR MOST OF MY LIFE, I trusted the system, especially the economic system, to serve as an engine not only of prosperity but of equality and freedom and individual rights under the law. I fully believed that once principles of law were at stake, all Americans were equal.

I assumed that the financial markets of America, and the people who serviced them, existed primarily for the good of the society, to assimilate data and efficiently process investment opportunities for the future growth of the national economy. I believed all of these things. In other words, I was a fool.

Enlightenment came by way of my ownership of 100 common shares of the Narragansett Capital Corporation, a publicly owned venture-capital company based in Providence, R.I., that specialized in leveraged buyouts. It sold stock and took the proceeds and invested them in many different business enterprises, including cable-television companies.

The company had been highly successful since its founding in 1959 by Royal Little. In more recent years, under the chairmanship of the founder's son, Arthur D. Little, its stock value had grown rapidly. In 1980, after adjustment for a stock dividend, Narragansett's stock price went up 54 percent; in 1983, the increase was 30 percent.

My modest investment in Narragansett did not fare too well the first year I owned it; 1984 saw a retrenchment in the booming bull market. But I believed in the proven skill of management in making assets grow over time, so I planned to hold on to my shares more or less forever.

On March 8, 1984, however, Narragansett announced that members of top management, most of whom were both officers and directors, were buying the company from the shareholders for a small increment above the current stock price (lower-level managers were not included in the venture, and some directors were neither officers nor involved in the buyout). According to a document sent to shareholders, management had decided to take the company private for a number of reasons.

First, they said, they had found it burdensome to work within the Internal Revenue Service Code. In 1978, Narragansett had opted to be classed as a registered investment company for income-tax purposes, allowing it to pass dividend and capital-gains income to shareholders without paying taxes at the corporate level. However, to keep that classification, the company had to maintain a widely diversified portfolio of investments, while taking a management role in only a limited number of its portfolio companies. Narragansett's managers said they had operated successfully in the past under those restrictions, but were finding it problematic to have to continue to do so.

This struck me as a richly disingenuous and bizarre ''explanation'' for taking the company private. The I.R.S. provisions had given both the company and its shareholders huge tax benefits, and had contributed to Narragansett's success. The managers were obviously fluent in every kind of calculation. I questioned whether people with their expertise would truly have difficulty functioning under such familiar guidelines.

In its proxy, management also complained that under the 1940 Investment Company Act, it was forbidden to give executives equity incentives. This reason for going private seemed even stranger. As far as I knew, Narragansett's managers had never been turned down by the shareholders when they had asked for a raise. Management had not even asked for a sizable raise. Moreover, there was no sign that the company was having any problem recruiting good management; the growth of the value of its portfolio of companies seemed to be proof of that.

Furthermore, the company could apply to the Securities and Exchange Commission for a waiver of certain rules and, if that waiver were granted, Narragansett could then give its managers stock options galore. Instead, management was applying for an exemption from the 1940 act that would allow it to take the whole company private.

Management made us a cash offer of $50, about 10 percent more than what the company was trading for in 1984. Alternatively, we could take about $66 a share in high-yield debentures. To ''assure'' us that the deal was ''fair,'' Narragansett's board of directors authorized a ''special committee of four independent directors'' - ones not affiliated with management - to evaluate the proposal and to hire Salomon Brothers, the investment banking firm, to issue a ''fairness opinion.'' In this fascinating but brief document, Salomon said that, using mostly information supplied by management and making no ''independent verification,'' it had carefully studied the value of Narragansett's assets and had found management's offer fair to us stockholders.

The total purchase price, as stated in the proxy, was about $128 million. This included legal fees to Wachtell, Lipton, Rosen and Katz, as well as other law firms, of about $1.1 million. These firms represented the interests of Arthur Little and the other managers. One firm also represented the ''independent directors'' who were evaluating the transaction. As far as I could see, these outside directors, without exception, ratified all the proposals of the inside directors in the going-private deal.